Enough with the Moral Hazard Argument.

The loans on tens of thousands of homes are going bad. 36,000 
mortgages are in arrears of three months or more. This is before we look at the shadow arrears that are occurring where people stay solvent only by eating into their savings, or where they have taken interest-only loans as a method of staying afloat. It also doesn't fully factor in the 17,000 households that cannot pay their mortgage and who are receiving mortgage interest supplement.

Everyone knows this. No one is doing anything about it. Banks have been exercising heroic levels of forbearance for primary residences in particular. Their failure to recognise the scale of these potential losses is not because of any social conscience, or even because of any government intervention on citizens’ behalf. The banks’ already-weakened balance sheets will get hurt badly if you lose your home, and they can’t have that. The banks’ forbearance is really for themselves.
 We need to begin thinking about ways to reduce the debts held by ordinary people, who bought beyond their means because they were offered credit by professionals who should have known better. We also need to consider the costs and benefits to society of debt-forgiveness.

Everyone from the Financial Regulator to the staff in RTE to my mother will cry ‘Moral Hazard!’ when talking about bailing out homeowners who signed their names to forms and borrowed money they couldn’t pay back. Moral hazard is a widely misused term. Moral Hazard exists when I behave differently when I know I’ll get bailed out if I fail. The argument goes that bailing out those who took out too much money for their homes constitutes moral hazard, because it encourages them to borrow more again later. The logic of this argument logic is flawed in several ways. 
 First, even if it were true, the Irish economy has already been
 pumped full of moral hazard because of the bailout of Ireland’s banks 
and bankers, almost all of whom, critically in middle management, and unbelievably, given the scale of their failures, still have their jobs.
 Second, the moral hazard existed at the point of sale--the bank
 selling the mortgage had more information about the likely evolution 
of the market, the debt-profile of the individual taking the loan, as 
well as the guidelines of their code of best practice, as well as the
 historically low levels of interest, to know that the person getting 
the loan was a bad bet. But the banks took the bet anyway. Recent 
research has shown that rising house prices were driven predominantly by increases in the size of mortgages that banks were willing to give, meaning the banks were the engine of the housing bubble, not interest rates or population. The average person just wanted a house to live in.

Third, the worry is that these bailed out homeowners would start
 taking out more debt, thinking they’d be bailed out again. Think about
 this for a second from your own point of view. Say a bailout happens 
for you and your wife with a 600,000 euro mortgage on your home. Say through some mechanism the bank forgives 200,000 euros of the mortgage, you keep your home, and you continue to pay a reduced amount to the banks. You and your wife have spent probably two years getting letters and phone calls from banks and solicitors, you’ve gone through the stress of nearly losing your home. A note about the debt forgiveness exists on your credit record. You are not going to start running up debt again, and even if you’d like to, you’ll be stopped. The moral hazard argument is flawed and useless. We should discard it.

The real argument against bailing out homeowners is the effects on the mostly-nationalised banks, and by extension the Irish taxpayer, of any bailout of indebted households. The Irish taxpayer owns a fairly large amount of most of the banks, and these banks would have to come back to either the international markets or the government for funding to stay alive.

The Irish taxpayer has to borrow to foot the bill to bailout those who borrowed excessively in the boom via further injections of capital to the banks.This is a bad thing. Fully cleansed, functioning banks, homeowners taken out of substantial negative equity and consuming and investing again, and a clear signal to the markets that Ireland has put its house--no pun intended--in order, may be worth it.

Following intense public debate, and serious scrutiny, if the benefit exceeds the cost in terms of encouraging economic growth--not to mention all of the ancillary social benefits of a large swathe of Irish society out of debt--then we should consider implementing a scheme of debt forgiveness.

28 Replies to “Enough with the Moral Hazard Argument.”

  1. "Third, the worry is that these bailed out homeowners would start
taking out more debt, thinking they’d be bailed out again. "

    Actually, an afternoon's browsing of economic "advice" sites such as Brendan Burgess's askaboutmoney will confirm this worry. Plenty of people in negative equity and up to their necks in other debts come along asking how to "upgrade" their house, buy an investment property or get their families to fund reckless businesses. I think you're mistaken if you think people would actually learn from this experience, and be grateful for the bailout. I think they'll take the cash and continue on as normal. Which is why for people like me, such a bailout would be the final straw.


  2. Paul, is this evidence in an Irish context? Can you send me a link?

    For me the main issue isn't moral hazard but macroeconomics effects of debt forgiveness. So say you forgive debt of 100,000 homes, but 100 homes practice what you describe. Would that be the final straw, or a small price to pay for stability?

  3. Hi Stephen,

    Forum is here: http://www.askaboutmoney.com. I find browsing it depressing, as it confirms to me that generally, Irish people really have learned nothing. There's a few derisory comments, for example, on Morgan Kelly's article yesterday, on a forum which roundly vilified him previously. Today the site owner is floating the idea that even small-time depositors should forfeit 10% - that is, yet another idea where those who were responsible should fund those who weren't.

    My feeling is that it would be a far higher percentage than 0.1% who feel, for example, that the bubble wasn't actually a bubble but normality, and that we'll get back there soon enough ....


  4. @ Paul, thanks, I'll look at that later, have to run now to teach.
    @ Mark, cheers for the link, that'll come in handy when I'm looking at the international evidence on this type of phenomenon.
    Cheers again for the comments, they are much appreciated.

  5. "People make mistakes, we need to move on."

    And then we make the mistakes again and again.


  6. Hi Paul,

    I am not sure if you fully understand what its like to have a mountain of debt hanging over you. More like a black elephant than a black dog. I don't think that people will forget their experiences soon.

    While, some people are born feckless, a large cohort of the people now straddled with unmanageable debt are not like this. If we don't deal with the excessive personal debt in the economy, domestic demand will be stunted for at least a decade. Your choice.

  7. "I am not sure if you fully understand what its like to have a mountain of debt hanging over you"

    No, since I have always made sure never to ever be in debt. I'm not sure why that counts against my opinion.

    " I don’t think that people will forget their experiences soon."

    Perhaps not, but people will disavow any responsibility for them. It was the fault of the banks, the politicians, etc. (And believe me as someone who wants to see arrests among those areas of society, they have their blame, but also no-one held a gun to those taking out mortgages that were many multiples of their salaries).

    "If we don’t deal with the excessive personal debt in the economy, domestic demand will be stunted for at least a decade"

    Ah, so we should transfer money from those who were responsible and saved to those who weren't so that they can spend the money. This appears to the same argument I see repeated in every situation like this and the reason why I'm beginning to think emigration is the choice I'm being forced to make.


  8. Hi Paul

    You make very good points.

    I am not suggesting there is an easy way out but we need to do something.

  9. @Paul,

    The example I give of the credit-constrained couple with a mark on their borrowing record restricting the provision of credit to them in the future should reduce incidences of over borrowing again dramatically. This couple would have a hard time getting a car loan, let alone another mortgage.

    The larger issue is: would bailing them out help or hinder the recovery of the economy?

  10. "The argument goes that bailing out those who took out too much money for their homes constitutes moral hazard, because it encourages them to borrow more again later"

    I don't think it is as specific as that. If there is some sort of the bailout the problem isn't that those who are bailed out will act imprudently again but that future generations will made reckless decisions as they think they will get bailed out if it all goes wrong.

    On your first and second points. Just because some moral hazard has already been created doesn't mean it is correct to create more. In fact it shows the danger of moral hazard as once you go down that road everyone starts crying out for help.

  11. Hi Dave,

    The bailed out homeowners would find it very difficult to build up debt again, were they so inclined, thanks to credit scoring and records of their behaviour. So its highly unlikely we'd generations of wasters as a result of debt forgiveness. The concept of moral hazard isn't appropriate here because once introduced into a system, the system is deformed by it regardless- it's a one/zero effect rather than adding 2 times some cardinal amount. Thanks for your comment.

    Do you agree that there are people who are in houses they will never pay the loans for? If so then either those loans are dealt with, or they aren't. If not, then the macroeconomic effects (not to mention societal) will be enormous.

  12. Nat,

    Thanks very much for your comment- you're right on the many subtle uses of the moral hazard argument, and of course the terms of loans and interest rates may serve to punish people who don't renege on their debts but do, in some sense, pay the reduced amount they are forgiven. I suppose it's a macroeconomic version of forbearance?

  13. Yes I agree some people will never repay their loans. Or at very least they will do it very slowly. The damage was done the day the loan was drawn down. As a people us Irish have shown a knack of not learning out lessons. If there is a bailout now I believe another housing bubble (or something very similar) will develop eventually inflated largely by the knowledge that there is a bailout waiting if and when it all goes wrong.

    I think the people in NE are stuck. They are effectively out of the game economically speaking. They will work their whole under the burden of their mortgage. They are a minority however I think sometimes people forget that. I think they took their chance and they have to live with it.

  14. Hi Dave,
    What if they aren't the minority? What if half of all houses with mortgages had this problem? Of course you're right, there will be another bubble eventually, but I think dealing with the present problem is enough to be worried about.

  15. I meant they represent a minority of taxpayers. I don't think anything can be done. I think a good idea for the future would be rather than non-recourse or recourse mortgages there should be shared recourse mortgages which would mean that in the event of a shortfall in the sale of the home that the lender and borrowed are responsible for 50% each. Makes sense to me and is a fair sharing of the risk and acknowledges that both sides are equallly responisble for any loses.

  16. Hi Dave, that makes sense, as do several other 'risk sharing' mechanisms-all would work to mitigate the effects of any future bubble, but wouldn't help our current predicament much, with swathes of potential bad debts en route from the residential sector. Don't forget that, for as long as the banks need the life support the government gives them, the banks balance sheets are of paramount interest to every taxpayer in the country. The health of these failed businesses is sadly our concern as well.

  17. Hi Stephen,

    I can agree to some extent with the problem you are diagnosing here but I cannot agree with the proposed cure. Apologies for the length. I should have escaped to bed before Vincent Browne came on. It is possible the empty rhetoric there got me even more worked up!

    You are right, that this has very litte to do with moral hazard, as it is usually defined. Those who are facing a mountain a debt are unlikely to want to be in this gut-churning situation again, while those who have avoided the debt glut this time around are unlikely to be encouraged to over-borrow because of a partial debt-forgiveness scheme in this instance.

    So if moral hazard is not the problem, how else could one oppose a partial debt-foregiveness scheme?

    It is clear we face the real prospect of a mortgage meltdown as this crisis prolongs. However, a mortgage is a long-term agreement (25 years plus) and most of those in negative equity are in the early part of these contracts. They expected to be able to pay back the full amount (plus interest) over the full life of the contract, but obviously are in severe difficulty meeting these repayments now.

    While there are people struggling to pay their mortgages, there are many, many people who are meeting their mortgage obligations (and maybe even overpaying). Per Central Bank data there was €124.7 billion of loans for house purchase outstanding to Irish households in January 2008. The most recent figures (Sep 2010) show that this has reduced to €107.8 billion. This is a substantial reduction in just 2.75 years.

    Some of this may be due to write-downs and revaluations, but I suggest that the vast majority of this is due to people paying off their mortgages. With a savings rate of 12% this is where the money is being put. Obviously, this is only being done by people who are in a surplus-income position to do so, but there are many people out there meeting their mortgages and we have to assume that many of these people are reducing their negative equity position because of this.

    Should these people, who have borne the cost of their mortgages, lose out simply because they have committed their money to paying their mortgages rather than using it elsewhere? Can we equitably discriminate between those people who have met their mortgages payments and those people who have not?

    What about those people who saved a large deposit to begin with for a house purchase and have repaid their mortgage since to the extent that they have reduced the negative equity they face? Can we fairly ask them to pay the mortgage of their neighbour who took out a 110% loan and has only being making interest-only payments?

    I cannot also see how this scheme will have much of a positive effect on economic growth. As the figures suggest there are thousands of people who are not paying their mortgages. They are committing little, if any, of their income to their mortgage. If some or all of their mortgage is annulled this does not give them any extra money for consumption. They have gone from spending no money on a huge mortgage to no money on a not-so-huge mortgage. Where is the consumption gain from these people? Should we give them some spending money as well?

    If there is to be a consumption gain, it will only be from those people who are paying their mortgage to begin with, but benefit from a reduced payment to a partially-forgiven mortgage. Why would be want to forgive the mortgages of those people who are actually meeting their mortgage payments? This might be placing a huge burden on them, but should we forgive their debt because we think they made a mistake and we feel sorry for them?

    As I said right at the start [way up there and they end is still way down there!] I do agree that we face a potential mortgage meltdown but I would be opposed to forgiving billions of euro of mortgage debt and adding it to our mounting national debt. Like Nat proposed above, I see the merit in some form of 'clawback', but Nat's suggestion only comes into play if the house is subsequently sold. Again why should we discriminate between people who sell their house versus those who don't?

    Do we know how much money is involved? Per latest released statistics to the end of June there was €6.9 billion on mortgage balances that were in arrears of 90 days or more. This is not small beer. There is probably a comparable amount being paid on an interest-only basis. This figure is not available. And this is only those are not meeting their repayments.

    The proposed scheme is for those in negative equity which is likely to be a multiple of this. A debt-forgiveness scheme could see €15 billion (a complete guess on my part) transferred to the national debt with an accompanying €1 billion per annum interest payment. It would take more than promissory notes to creatively account our way out of that one.

    My suggestion would not be a debt-forgiveness scheme where the State assumes the burden of the principle and interest payments of a portion of someone's mortgage. In my view, someone has taken out a mortgage so it should be that every effort is made to ensure that they pay it back. I suggest that if we need to help people with mortgage debt in the current crisis, that the state assume the interest cost of a portion of the mortgage.

    So using your example of the €600,000 mortgage. I would split this loan into two. Say €300,000 remains with the mortgage holder and they make principle and interest payments on this over an agreed term. The other €300,000 is split away and the State covers the interest payments on this loan - and only the interest payments!

    The scheme lasts for a certain period, possibly anything from say 5-10 years. At the end of the period, the €300,000 is added to the outstanding balance of the mortgage that remained with the householder and they resume full repayments. By that stage, it is likely that inflation will have reduced the real value of this debt and hopefully the householder will be in a better position to meet the mortgage obligations they signed up to. In essence, this is what the current benefit of mortgage interest relief does but this scheme is much more explicit.

    Using the, admittedly back of the envelope, aggregate numbers outlined above, this would impose an annual €1 billion interest cost on the State. It could be less as most mortgages are at lower rates than the State can borrow! This would be a substantial cost but we would avoid the €15 billion principle cost as we transfer the principle back to the original mortgage holder at the end of the scheme. There is a pre-determined stop on the period for which this interest cost must be carried, whereas the full debt-forgiveness scheme can see this cost carried in perpetuity.

    This scaled-down or temporary debt-forgiveness scheme offers some short-term benefit to those currently in dire straits. It is essentially a zero-interest offer for a number of years that would give them a manageable repayment on the remaining debt. There may even be a consumption gain if the repayments of some of those who enter the scheme is below their existing payments. Of course, these people may save this amount in expectation of the returning debt amount, but if they can afford to save this money they probably weren't in such a bad spot to begin with.

    I have not given sufficient thought to how entry to the scheme would be administered. How would entry to your proposed debt-forgiveness scheme work?

    Per your last paragraph, I cannot see how the benefits of a debt-forgiveness scheme can exceed the costs. In fact, where are the benefits? We cannot magic away the debt. We will not have "a large swathe of Irish society out of debt". We will simply have transferred individual private debt to social public debt that Irish society still carries. The country will still have the same aggregate debt burden but we will have just changed who will have to pay it. Any increase in spending by those who benefit from the scheme will have to be offset by increased (future) taxation on those who have to pay for it. We have assumed the gambling debts of our developers into the national debt and I cannot see that working out too well for us.

    Of course, we could renege on the debt entirely and "burn the bondholders!!" You might be able to sell me that one. But paying someone else's mortgage. No thanks. Thanks, though, for raising an important issue and stoking debate. It is very necessary.

  18. Seamus,

    Thanks for your perceptive and thoughtful comment--length is no issue on my blog, at any rate.

    Let me first say that I don't care what mechanism is advocated to deal with the debt problem. My interest is purely the health of the macroeconomy. I do say in the piece 'through some mechanism', assuming the actual one will be a composite of several approaches, dictated largely by political concerns. The interest cost version you suggest would work, as would the suggestion on RTE of a 5 year 'freeze' on interest payments, which amounts to the same thing. Nat's suggestion is wholly pragmatic--getting 400k/600k rather than 0k/600k is preferable in every case.

    You're right that if we just transfer private to public debt, the debt level remains the same. Burning bondholders is something I've reluctantly come around to--I believe aggregate debt levels should be reduced at this point.

    How would I discriminate between mortgage holders? Remember, any process of debt forgiveness damages the borrower's ability to borrow more in the future via a note on their credit record. Only those households willing or desparate enough to take such a hit would enter the scheme. The threshold could be set quite high to stop all but the most determined strategic defaulters. Remember also that lagged effects matter in the macroeconomy: consumption increases in period 1 when the debt gets forgiven might outweigh any interest cost borne later on if the growth/debt dynamics are favourable. The question I'm posing is in fact the same as yours--do the benefits outweigh the costs to society for some kind of debt relief? If so, I say do it. If not, then don't. I'm happy to rely on evidence-based policy making of this kind.

  19. "Moral Hazard exists when I behave differently when I know I’ll get bailed out if I fail." Bankers KNEW they were too big to fail. Bank investors, including all flavours of bond holders, also knew this. Therefore moral hazard, by definition, exists as a concept for bankers/bond holders/share holders but our Government in it's wisdom decided that fateful night in Sept. to forget all about the principles of capitalism and buy themselves enough time to cash in.
    As far as mortgage holders & moral hazard, this is a bit tougher as I suspect most did, and would continue to, behave rationally based on the information available to them at the time. The fact that this information was totally wrong was not their fault.

  20. Stephen, if this would make a sensible macroeconomic policy I will eat my hat.

    This is simply a redistribution of capital within Ireland. Nothing more nothing less. The net financial wealth of Ireland is unchanged and our foreign debt is unaffected.

    I leave more extensive comment on what I perceive as a poorly presented argument to my blog.

  21. @"Gekko",

    Thanks for the comment. One point of clarification: The 'recent research' I refer to is published as chapter 7 of my new book, hence the lack of a hyperlink. It's published as a working paper though here: http://www.ucd.ie/t4cms/wp09.32.pdf, see page 11 particularly.

    This need not be a simple redistribution of wealth around Ireland. You're clearly convinced it is, but I'm not going to try to change your mind.

  22. Stephen,

    Unless you can identify which current foreign resident creditors to Ireland, be they soveieng bond holders, bank bond holders, foreign direct investors, will be writing off some of their assets this will remain a domestic wealth transfer. I don't know how you can think otherwise.

    I don't share you interpretation of Morgan's paper. Regardless, you haven't identified a moral hazard, but only illustrate the lack of rational expectations.

  23. @ Gekko,

    Then it seems we are unable to agree on an interpretation of anything, which is a pity. Thanks again for reading my work and taking time to reply.

  24. Stephen's first argument about moral hazard... well, as the saying I heard as a child goes, two wrongs don't make a right. As someone who marched against NAMA when few others bothered, I don't feel shy about arguing against "NAMA for Ali O'Riordan".

    "Say a bailout happens 
for you and your wife with a 600,000 euro mortgage on your home. Say through some mechanism the bank forgives 200,000 euros of the mortgage, you keep your home, and you continue to pay a reduced amount to the banks.


    The Irish taxpayer has to borrow to foot the bill to bailout those who borrowed excessively in the boom via further injections of capital to the banks.This is a bad thing. Fully cleansed, functioning banks, homeowners taken out of substantial negative equity and consuming and investing again"

    So let me get this straight. Taxpayers, most of whom couldn't afford 600K houses during the boom, and definitely can't afford them now, are expected to fund people who purchased such properties to the tune of 200K each, in order that they.... make more investments?

    I mean, the money comes from _somewhere_ right? The banks don't merely magic it off their books. Someone ends up paying, either through some form of tax or bank charges. If we're just playing musical chairs with the money, passing it from John in Crumlin to Lorcan in Ranelagh then the "stimulating consumption" argument seems to be nonsense.

    It's not to say I'm not in favour of some help to people. But the scheme being put forward by Lucey and co. seems to be be a sop to the upper-middle classes, as shown by last night's hilariously misjudged Primetime (I thought my Facebook feed would blow up with the number of comments about it, noticeable some from friends of mine who are not political but were still outraged at the national broadcaster holding up people living in castles and people who bought multiple investment properties in a country with virtual slave labour as people to be particularly sympathetic about).


  25. Paul,

    Thanks for the comment. You are correct, there are two main issues: would *any* plan of debt writedown work, and who would pay for it. I believe a debt writedown would work (in a macroeconomic context) because it would force banks to recognise losses, reduce the debt burden in society, and get the economy back on track via increases in aggregate demand. Now I'm open to ideas and evidence, as I've always said, on whether the previous statement is true or false. But I'd need to be shown that evidence first before simply saying no. If I have to sit down for a month and crank out a model to help start answer the question, I'll do that.

    Who pays? The banks' equity capital, then their bondholders (at various levels) first, then the taxpayer. If the EU says no burning bondholders, as is likely as a condition of continued support, it's the taxpayer on the hook.

    It's important to recognise up front that the taxpayer is going to pay *in any event*. These are bad debts, they just haven't been formally recognised as such yet. That doesn't mean they aren't there, that doesn't mean they aren't having an effect on behaviour in the current period. It just means we're all choosing to ignore them. How very Irish.

    You raise the issue of equity. I'm concerned with this fundamental issue also, but I can't see a way to attempt to solve the issue of residential debt without causing taxpayers some harm. I understand why you're against that, being a prudent person, but you must recognise that this problem isn't going to go away, it is going to get worse, and your taxes will be taken, at some point, to recognise these losses.

    I saw the Primetime program, and my first thought was that none of the three couples interviewed asked for anything. They were up front with taking ownership for their failures, took their losses on the chin, changed their consumption patterns, and seemed to be moving on with their lives as best they can. I'm not in agreement that these cases would be good examples of the type of writedowns I"m talking about.

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